Bank of America Merrill Lynch (BAML) has increased its S&P 500 (INDEXSP:.INX) 2013 end of year target from 1600 to 1750 in light of expected earnings growth for the rest of this year, they announced in a recent report. Falling ERP (equity risk premium) and some changes in the way the company predicts growth also factor into the change.

BAML

BAML revises it prediction model

While the upwards revision is mostly based on the bank’s Fair Value model, showing genuine optimism about the ongoing recovery, it also reflects changes in the predictive model itself. The BAML report states, “if the last several years have taught us anything, it is that fundamentals sometimes take a backseat to sentiment, technicals, and macro. As such, we have explicitly incorporated [them] into our market forecast.”

The company’s Fair Value model predicts that the S&P 500 (INDEXSP:.INX) will close out the year at 1720, but other models point to even higher values, sometimes 1800 or more. BAML is giving some credence to these other forms of valuation by adjusting its official target.

Risk is still high relative to pre-crisis levels

The BAML report also notes that ERP still has plenty of room to drop, which would give another boost to the S&P 500. Pre-crisis ERP levels were well below 400bp, as opposed to more than 500bp now, and the report expects them to return to historical levels in the short term. Excessively high ERP has been prolonged by a series of financial scares that have passed largely without incident, including the recent US presidential election, the fiscal cliff, sequestration, and fears that the Chinese economy could experience a hard landing.

Even as new issues appear, BAML expects them to have a diminished impact on ERP as visibility improves. The report says that the company has reduced its normalized risk premium assumption for year’s end from 600bp to 475bp, a further contraction of 25bp instead of a net increase.

normalized equity risk premium

Don’t panic over pullbacks

The BAML report warns that historically, situations like this are met with some amount of pullback, and that investors should extend their investment horizon and see a temporary drop in equity prices as a good time to buy. Pullbacks of at least five percent of total value occur three times per year on average, and in the current bearish equities market could easily lead to an overreaction among investors.

Sell Side Consensus Indicator

The report notes that Wall Street consensus on equity allocation has been a historically consistent contrarian indicator, and that strategists’ extreme bearishness is itself a good reason to be bullish on equities over the next year. The S&P 500 (INDEXSP:.INX) has already risen 14 percent this year, and historically when the market starts off strong it grows another 7 percent in the second half of the year.